I have long thought that the next move in local official interest rates would be down. Although the Reserve Bank of Australia has of late appeared comfortably on hold, to my mind, persistent low inflation and an eventually rising unemployment rate (as the labour intensive home building boom slowed) would eventually force the RBA’s hand.
As it turns out, however, this week’s lower than expected March quarter consumer price index result has significantly increased the odds that the RBA will act as early as next week. Annual underlying inflation has dropped from around 2% to 1.5%, which is a step down from what the RBA was expecting.
As a result, I reckon a rate cut on Budget day next Tuesday now seems more likely than not, though it promises to be one of the most interesting and “finely balanced” decisions of recent times.
Of course, there are good arguments for the RBA to do nothing. After all, the economy does not presently appear to need a rate cut. The labour market is robust, with a downtrend in the unemployment rate over recent months. Business sentiment as measured in the highly regarded National Australia Bank business survey has also lifted to above-average levels. The economy grew by a respectable 3% over 2015, and house prices in the key cities of Sydney and Melbourne remain firm.
With interest rates also low, and downside risks to the economy persisting, there’s also an argument that the RBA should “save its ammunition” so that it can act to cut rates later if need be.
There’s also debate over how persistent unusually low inflation will prove to be. After all, as the RBA has previously noted, lower petrol and electricity prices (the latter partly due to regulatory demands) are currently being passed through the cost chains of many business, helping dampen both headline and underlying inflation. This dampening effect on inflation, however, will pass as and when these prices stabilise.
Last but not least is the political situation. It might be argued the RBA would not want to cut next Tuesday as it could “steal the limelight” from the release of the Federal Budget.
That said, the arguments for a cut in rate are also strong – and on balance, I consider even stronger. For starters, as an inflation targeting central bank, the RBA usually likes to link its interest rate decision to inflation results. History shows the RBA is more likely to change rates in the month following quarterly CPI results, which also happens to be a few days before the RBA releases its quarterly Statement on Monetary Policy (which contains its updated set of medium-term economic forecasts). These “windows of policy action” are February, May, August and November.
The RBA also usually likes to hang a rate cut on a “good” low inflation report, rather than respond to signs of weakness in the economy. And, perhaps the most critical argument of all, were the RBA not to cut interest rates next week, it would probably have to forecast underlying inflation at or below the lower threshold of its 2 to 3% target band for the foreseeable future in the May Statement on Monetary Policy released a few days after the Board meeting.
As regards the economy, it’s also likely that much of the improvement in business sentiment of late has reflected the substantial decline in the $A last year – which is now at threat given the $A has since rebounded. Indeed, the decisions by the central banks of Europe and Japan to ease monetary conditions further this year – and of US Fed to delay indefinitely another rate hike – has meant Australia’s relatively high interest rates (by global standards) are playing a more important role in keeping the $A high. Arguments that a rate cut would have no effect in lowering the $A has been crushed by the currency’s steep drop in recent days just on the expectation of a cut.
The political case not to cut is weak. Indeed, recent history demonstrates the RBA has not been frightened to change interest rates in the middle of an election campaign. And the fact that it might cut rates on Federal Budget day is caused by the Turnbull Government (who changed budget dates) not the RBA.
Last but not least, we’ve also had a de-facto mini rate hike in recent months which the RBA might now be prepared to offset. According to data compiled by the RBA itself, the average “discounted” standard variable bank mortgage rate has lifted by 15 basis points since October last year.
As I indicated, there are good arguments on both sides. But at the end of the day, the RBA’s job is to target a rate of inflation between 2 to 3% over the foreseeable future. On present trends it will be hard to make such a forecast without a stronger economic growth trajectory, and that will likely only come with a lower profile for official interest rates.